Though prices are peaking, liquidity is ample and fundamentals remain strong, delegates hear. Al Barbarino reports.
After a dismal – if not abysmal – first quarter, where CMBS all but ground to a halt, the industry has some momentum as spreads have tightened and deal flow begins to pick up, delegates heard at the CRE Finance Council’s annual conference in Manhattan in June.
But no one was jumping with excitement. The current pace of issuance is about 50 percent below where the CMBS market stood last year. And, annualised, that works out to just about $58 billion for the year, noted one speaker representing a major US bank.
Delegates were well aware that the glory days of CMBS are gone. The whopping $228 billion done in 2007 is a thing of the past and likely never to be seen again. There’s a new bull market in CMBS, the banker declared, and that bull market in the foreseeable future will not exceed $125 billion per year.
The consensus among panelists and delegates at the event was that, despite the troublesome stretch for CMBS, it is gaining momentum. Overall, the CRE market has slowed slightly from one year ago, but there is still plenty of liquidity and fundamentals remain strong. Pricing has begun to peak, set to rise just a few percentage points this year across asset types, according to estimates given, compared to the 17 percent boost seen last year.
But underwriting remains conservative, especially when compared to the peaks of the last cycle. In fact, a majority of attendees were in agreement that underwriting has improved since last year, while others said standards hadn’t changed. But when one speaker asked the room who thought underwriting was worse this year compared to last year, not one person raised a hand.
The market share lost by CMBS has also quickly been absorbed, going mostly to the banks, who have only increased their footprint – so much so that another banker at the event noted that the Fed has “come out to us and said, ‘don’t put any more real estate exposure on your portfolios’.”
Bank lenders have captured significant market share from CMBS conduit lenders whose originations stalled in Q1 2016, showed a CBRE report leading into the conference. Banks accounted for 43 percent of non-agency CRE loan origination in Q1, upping their market share from 28 percent in Q1 2015.
CMBS conduits meanwhile accounted for only slightly more than 10 percent of loan deal volume, way below the level of 18 percent in Q1 last year – and one of the lowest quarterly market shares in several years.
This year could also mark the first year that insurance company lending volume exceeds that of CMBS, noted another conference delegate, with originations estimates at the CREFC given in the $70 billion range.
Backing that up, a CREFC/Trepp survey released during the conference showed that insurance companies reported ongoing strong performance and increased allocations to commercial mortgages during the second half of 2015.
Commercial mortgage holdings averaged 11.08 percent of total invested assets for survey participants, representing 25 insurance companies with a combined $204 billion in loan exposure, marking a 40 basis point increase from year-end 2014 and indicating increasing allocations to commercial mortgages by insurance companies.
Survey participants also added $44.7 billion of new mortgages in 2015, a more than $7 billion increase over the prior year. Notably, roughly 90 percent of the new originations came from “New Business/Financing,” which could include refinancing of maturing loans from elsewhere.
Ironically, the often feared risk retention rules, part of the 2010 Dodd-Frank regulations, were cited several times as a reason for more conservative underwriting, and as people start to make sense of the rules they are being viewed more favorably – for the market as a whole, at least.
Starting in December, CMBS issuers will have to retain a 5 percent slice of every tranche in a new deal they issue – or designate a B-piece buyer to take on that risk.
The rules have created some confusion in an already volatile CMBS market, but a milestone came leading up to the conference, when the first CMBS deal that’s in compliance with the rules was sent to ratings agencies for preliminary feedback.
Wells Fargo, Bank of America and Morgan Stanley are teaming up on what could become a circa $1 billion transaction, and the deal will likely serve as an important ‘guinea pig’ to make sure issuers are conforming to the rules before they go into effect in December.
Another major concern continues to be the coming ‘Wall of Maturities’, which has been mostly brushed off in recent months as refinance-able after initial panic rippled through the market beginning early last year.
But anxiety surrounding the Wall seems to be building up once again. Morgan Stanley came out with a rather bearish estimate at the conference, saying that it believed the refinance rate could be as low as 65 percent for the remaining maturities coming due this year and just 50 percent in 2017.
By year end about $350 billion in loans will have come due this year; in 2017 the number rises to $400 billion. And the more difficult loans to work out are soon to make their grand appearance.
“It will be interesting to see during the latter part of this year how much of that will have trouble being refinanced, and I think the answer to that is ‘a lot,’ but nobody likes to admit it,” an executive with a leading financial intermediary said at the event.
During a panel put together to address the wave of upcoming CMBS maturities, an executive with an issuing CMBS bank lender noted that, while he feels the market is well-positioned to handle it, the intense competition from other investment groups will likely continue to take market share away from CMBS.
“Our share is shrinking and it’s shrinking fast,” the banker said. “There is so much liquidity and there is more competition from the banks and the regional banks than at any other point.”
Panelists noted that there were always flaws with CMBS and that those flaws remain. But there’s a big difference today. Back in 2006 and 2007 borrowers gravitated towards CMBS because they could get cheaper capital and fewer restrictive loan covenants.
“They didn’t do it for the servicing experience,” a special servicer on the panel admitted.
Today, many of those same borrowers are simply “fed up” with having to deal with special servicers and are now willing to pay a bit more and agree to lower loan-to-values in order to obtain a balance sheet loan from a bank or insurance company lender.
“Because issuance is down and the level of uncertainty it has created, a lot of the assets we thought would have been financed have been coming in and transferred into our portfolios early,” the special servicer said, referring to recent maturity defaults and imminent maturity defaults. “We think that will continue.”
The retail conundrum
A panelist at the conference noted that he had recently visited a retail store to get a feel for a certain cooking pan, only to order it on Amazon.com on his way out the door.
This mindset underscores the uncertain future of brick and mortar retail, as embattled stores continue to close, once-formidable retailers file for bankruptcy and enclosed malls suffer due to the loss of major retail tenants.
Retail was portrayed at the event as being among the most concerning of the main CMBS asset classes, and the picture became gloomier when considering that retailers, particularly those in secondary and tertiary markets, have relied heavily on CMBS in the past.
Data presented at the event showed that 22 percent of major market retail is backed by CMBS financing, compared to 40 percent and 50 percent for the secondary and tertiary markets, respectively.
“This type of retail is going to have a high sensitivity to the availability of CMBS and there could be some real takeout issues,” said one speaker, representing a private lender that specialises in special situation investing.
Losses are piling up. CMBS 1.0 loans collateralised by retail have already experienced $3.2 billion in losses across 102 loans, according to data from Morgan Stanley.
While it’s well known that regional malls and department stores, once the lifeblood of retail, have suffered staggering losses, the data presented at the event was still eye opening for delegates, highlighting that the problem is systemic and that business models will need to change if traditional retailers intend to have a viable future.
Not a single department store today is indexing higher than it was back in 2006, the speaker noted, rifling through a number of stats showing the pronounced 10-year decline of major retailers: Nordstrom is at 95 percent, Macy’s at 89 percent, Bon-Ton at 64 percent, J.C. Penney at 63 percent and Sears at just 60 percent.
“Sears has fallen off the cliff and no one wants to think or talk about it,” he said. “They are at negative profit margins, meaning that they do not make any money.”
Meanwhile, as profits plunge and the stock prices of most notable retailers suffer, Amazon is sitting pretty with an 80 percent year-over-year increase in its stock price.
There’s no clean and cut remedy for traditional retailers and big boxers, though slowly but surely some are adapting to market changes and have had plenty of success with Internet sales.
E-commerce apparel sales are growing at 20 percent per year, and a majority of the top 15 sellers were traditionally brick and mortar stores, one panelist noted.
Amazon began opening its first physical stores last year, signaling that brick and mortar retail is, in fact, not dead. But closing large, outdated stores, by the hundreds, could help traditional retailers cut away dead weight and adapt new business models.
Ratings agencies acknowledge optimism
The latest issuance tally at the time of the CREFC conference was just about $28 billion. But as spreads tighten and CMBS picks up at least some steam, there is optimism that CMBS will continue to fill a role in the market, albeit a smaller one.
“People are feeling a lot better than they were three to four months ago,” said Fitch Ratings managing director Huxley Somerville.
“It was a different time in Q1 and issuers had very little margin for error in pricing and execution,” added Eric Rothfeld, a managing director of commercial mortgage at Fitch.
But there was a positive result, as highlighted by not only the Fitch analysts but a number of delegates at the CREFC conference — that credit quality has improved.
“There was a lot of discussion with us, the other ratings agencies and the B-piece buyers who were trying to shape the pool as best as possible, and the result was increased quality,” Rothfeld noted.
Leading into the conference, Kroll Bond Rating Agency noted in its monthly report that lending is picking up at several CMBS origination shops and overall deal flow is picking up, while conduit loan-to-values declined and spreads tightened through May.
Ten private label securitisations priced in May, and there are seven deals in the pipeline for June and July, according to the report.
Though deal sizes have on average been 20 percent smaller than last year’s, the balance of two of these conduits could exceed the 2015 average, the agency added.
The May deals included seven conduits ($5.6 billion), one seasoned loan ($259.7 million) deal, one transitional pool ($230.2 million) and one single-family residential ($255 million) transaction.
Conduit spreads tightened with last cash flow AAAs ranging from S+110 basis points to S+130 bps, while the comparable figures for credit bonds (BBB-) were S+565 to S+720. KBRA’s three-month rolling LTV average of 99.5 percent was the lowest it has been since February 2014.
A separate KBRA report did suggest that ratings shopping continues to occur. The conduit deals KBRA rated so far this year were superior to the non-KBRA deals, according to the report, yet the agency was selected less frequently to rate deals, on 56.5 percent of conduits through the first five months of 2016 compared to 71.7 percent for all of 2015.
“It is fair to say that our view on the non-KBRA rated conduits, which was generally not as favourable, was a factor in our not being selected to rate the deals,” said Eric Thompson, a senior managing director at KBRA.
One of Fitch’s main concerns continues to be credit barbelling, which it says is “becoming more commonplace in US CMBS, which may place transactions at much greater risk for losses over time.”
Barbelling is a wide dispersion of credit risk within a transaction, often with larger high-quality deals overshadowing smaller deals of poor quality.
“A notable example is two recent Fitch-rated deals that launched and priced within days of each other: MSBAM 2016 C28 and WFCMT 2016-NXS5,” Fitch noted. “While the pools look very similar using average credit metrics, they have very different credit profiles when observed more closely and Fitch credit enhancement reflects this difference.”